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The Levy Economics Institute of Bard CollegePublic Policy BriefNo. 106, 2009CAN EUROLAND SURVIVE?stephanie a. kelton and l. randall wray
Contents3PrefaceDimitri B. Papadimitriou4Can Euroland Survive?Stephanie A. Kelton and L. Randall Wray20About the AuthorsThe Levy Economics Institute of Bard College, founded in 1986, is an autonomous research organization. It is nonpartisan, open to theexamination of diverse points of view, and dedicated to public service.The Institute is publishing this research with the conviction that it is a constructive and positive contribution to discussions and debates onrelevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the authors.The Institute believes in the potential for the study of economics to improve the human condition. Through scholarship and research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United Statesand abroad.The present research agenda includes such issues as financial instability, poverty, employment, gender, problems associated with the distribution of income and wealth, and international trade and competitiveness. In all its endeavors, the Institute places heavy emphasis on the values of personal freedom and justice.Editor: W. Ray TowleText Editor: Barbara RossThe Public Policy Brief Series is a publication of The Levy Economics Institute of Bard College, Blithewood, PO Box 5000, Annandale-onHudson, NY 12504-5000.For information about the Levy Institute, call 845-758-7700 or 202-887-8464 (in Washington, D.C.), e-mail info@levy.org, or visit the LevyInstitute website at www.levy.org.The Public Policy Brief Series is produced by the Bard Publications Office.Copyright 2009 by The Levy Economics Institute. All rights reserved. No part of this publication may be reproduced or transmitted in anyform or by any means, electronic or mechanical, including photocopying, recording, or any information-retrieval system, without permission in writing from the publisher.ISSN 1063-5297ISBN 978-1-936192-00-7
PrefaceSocial unrest across Europe is growing as Euroland’s economycollapses faster than the United States’, the result of falling exportsand a weaker fiscal response. The controversial title of this briefis based on a belief that the nature of the euro itself limitsEuroland’s fiscal policy space. The nations that have adopted theeuro face “market-imposed” fiscal constraints on borrowingbecause they are not sovereign countries. Research AssociateStephanie A. Kelton and Senior Scholar L. Randall Wray foreseea real danger that these nations will be unable to prevent anaccelerating slide toward depression that will threaten the existence of the European Union (EU).Euroland’s economic performance has converged to one thatis uniformly poor for all members (i.e., chronically high unemployment and slow growth), a situation consistent with nonsovereign nations’ relying on export-led (mercantilist) policy. Moreover,the capital markets have doubts about the ability of member governments to cover their debts. Thus, bond yield spreads havewidened during the downturn, indicating that liquidity and defaultrisks are expected to rise, and that national defaults are plausible.The Federal Reserve (Fed) is lending to foreign central banksvia swap lines and acting as the global lender of last resort. Theauthors maintain that the Fed does not face currency risk whenit engages in overseas lending and that its actions have been aform of life support for Euroland. The question is whether thereis sufficient political will for U.S. policymakers to continue thissupport as the Fed’s financial services explode.The authors outline how fiscal policy operates in a sovereign nation that issues its own currency. Since a sovereign government spends by crediting bank accounts, its spending is neverconstrained by taxes or bond sales. There is no reason for ratingagencies to downgrade government debt, since it is sovereigndebt with no default risk. Moreover, a sovereign government canbail out its state and local governments. This option as it relatesto the European Parliament is unknown, since the EuropeanCentral Bank is practically prohibited from taking over the debtsof member states.The only way out of this crisis is to use sovereign power andramp up government spending. Rather than shoring up investorconfidence, spending increases in Euroland have fueled concernsabout the impact on government debt levels and the future ofthe euro. Nearly half of all member states are projected to breachthe 3 percent deficit-to-GDP limit—debt that has to be purchased in (substantially tightened) private capital markets. Thefinancial markets are expressing an unprecedented preference forGerman treasury issues, resulting in a dramatic widening of yieldpremiums against the bund. And in response to the threat ofbudgetary-related penalties by the EU’s executive arm, some statesmay simply abandon the euro.The authors believe that the Maastricht Treaty does not constrain government spending, so any changes to this legislationwould do little to increase fiscal freedom. This argument is basedon the notion that financial markets (by pricing risk) are likelyto discipline governments before the treaty limits are reached.When a nation is perceived to be a “weak” issuer, the markets caneffectively shut down its ability to stabilize conditions within itsborders—a fundamental flaw that the authors have warned aboutsince the euro zone’s inception. Unless these nations can avertsuch financial constraints—for example, by establishing a sizableEU budget and giving the European Parliament fiscal authorityon par with that of the U.S. Congress—prospects for stabilizingthe euro zone appear grim. Since such measures are likely to bepolitically, culturally, and socially difficult, a trend toward dissolution remains a possibility.As always, I welcome your comments.Dimitri B. Papadimitriou, PresidentNovember 2009The Levy Economics Institute of Bard College3
Can Euroland Survive?IntroductionGovernments worldwide have spent the last year or so trying tofind the right mix of fiscal and monetary policies to deal withthe worst global economic meltdown since the 1930s. Virtuallyall central banks have responded by cutting interest rate targetsto historic (or near-historic) levels. Most have also intervened aslenders of last resort. In the United States, the Federal Reserve(Fed) has injected massive amounts of liquidity into the bankingsystem—bank reserves have risen from about 20 billion inSeptember 2008 to around 800 billion today—and also easedglobal liquidity conditions by adding hundreds of billions of dollars to overseas markets through dollar swap-line arrangements.In addition to central bank lending, treasuries around the worldhave turned to fiscal “stimulus” packages like the 787 billionAmerican Recovery and Reinvestment Act (ARRA) passed by theU.S. Congress in February 2009. The current estimate is that theU.S. Treasury and the Fed have committed a total of 8.8 trilliontoward crisis resolution—an amount that still appears too smallfor the job at hand.1In this brief we show that Euroland—comprising the 16, outof a total of 27, European Union (EU) countries that use theeuro—is in a particularly difficult situation, and not simplybecause its policymakers fail to realize the scope of the problemor that the Maastricht Treaty restricts the size and nature of possible interventions. Rather, we continue to argue that the natureof the euro limits fiscal policy space (Bell [Kelton} 2003, Sardoniand Wray 2006). At the level of individual member states, theeuro is not a sovereign currency, so it imposes serious constraintson the ability of states to mount a substantial fiscal stimulus. Atthe EU level, parliament spending amounts to only 1 percent oftotal GDP, an amount far too modest for the job at hand. By contrast, the U.S. Treasury spends the equivalent of 20 percent ofGDP, which will climb sharply this year and next.2 It is not inconceivable that direct federal spending will rise well beyond 25 percent of GDP as part of the U.S. government’s attempt to restoreeconomic growth. If so, the rise in spending would represent arelative increase that is five times the total annual spending ofthe European Parliament.We realize that the euro countries are also increasing government spending and are likely to increase budget deficits signifi-cantly, adding to any stimulus arising from Parliament. We alsorecognize that these nations have a greater capacity to deficitspend than the individual U.S. states, many of which are running(illegal) deficits and thereby triggering large reductions in spending that are adding to depressionary pressures in the UnitedStates. Still, we maintain that Euroland’s fiscal policy space (atboth the aggregate and state levels) will be insufficient to dealwith the current crisis. And this problem will be compoundedin the event the Fed imposes lending restrictions on foreign central banks, or if the U.S. economy fails to recover quickly.Meanwhile, there is growing unrest across Europe, signaling the first serious test of the sustainability of Euroland. Whilewe raise a provocative question in our title—Can EurolandSurvive?—we believe the union’s dissolution is unlikely. Rather,default on euro-denominated debt by one or more euro nationsis more plausible. Although the probability of default on dollardenominated debt (e.g., swap-line commitments) might behigher, such repercussions will be borne by the United States(mostly in the form of political fallout), as Americans wonderwhy the Fed has been lending hundreds of billions of essentiallyunsecured dollars to foreign central banks. The most likely (andcertainly the most desirable) outcome of the crisis in Eurolandwill shift greater fiscal responsibility toward the sovereign; that is,the European Parliament. While the economics of this transitionare fairly easy to discern, the real problem is politics. Even if thecrisis is resolved, the prospects for further expansion of the euroarea seem uncertain at best.The Global CrisisThe U.S. economy is collapsing at a pace not seen since the early1980s. Real GDP fell at an annual pace of 6.4 percent in the firstquarter of 2009.3 In the same period, fixed investment fell at anannual rate of 37.6 percent, while personal income fell at an 8percent pace. As of late summer, the economy had lost almost 7million jobs since the recession began in 2007. Consumer pricesfell at the fastest clip measured since the quarterly index wasbegun in 1947. Consumer spending and spending on durablegoods were down 4.3 percent and 22 percent, respectively, in thefourth quarter of 2008. Although “big government” and a “bigcentral bank” will constrain the collapse, this recession will beremembered as the Great Recession, setting it apart from themore benign contractions to which we have grown accustomedsince the Great Depression.Public Policy Brief, No. 1064
Protests and riots broke out worldwide toward the end of2008. Social unrest was perhaps most severe on the periphery ofEuroland, with the exception of violent demonstrations inIreland in February 2009. Russia imposed import tariffs of 30percent on automobiles, 15 percent on farm kit, and 95 percenton poultry above quota levels. More than 10,000 peopleprotested the Latvian government’s handling of the crisis, whichcalled for budget cuts of 25 percent (including a governmentemployee wage cut of 15 percent) and early elections. The protestturned into a riot, with attacks on police and the parliamentbuilding. GDP in Latvia is projected to fall by 5 percent this year,following a drop of 2 percent in 2008. In Lithuania, police fendedoff 7,000 protestors using rubber bullets. Outside the Icelandicparliament building in Reykjavik, police used tear gas against2,000 protestors, culminating a week of violent demonstrationsagainst the government’s handling of the economic crisis; theprime minister agreed to resign the following day. Apart fromIceland, which arguably has the oldest parliamentary democracyin the world, democracy has at best a shaky foothold in many ofthese countries, leading to fears that the widespread unrest couldsignal a turn toward authoritarianism.Japan’s economy is in freefall—perhaps the fastest downward acceleration toward depression ever seen in the developedworld. The World Bank projects that 100 million more peoplewill fall below the poverty line worldwide, and that 50 millionmight lose their jobs over the next year. Euroland is collapsingfaster than the United States because its exports have dried upand its fiscal response has been weaker. GDP growth within theEU-16 was down 1.5 percent in the fourth quarter of 2008, a contraction of 6 percent on an annualized basis. The sharpestdeclines were in Euroland’s three largest economies: Germany(-2.1 percent), France (-1.2 percent), and Italy (-1.8 percent)(Pfanner 2009). To address the worsening economic conditions,the Bundestag (the lower house of the German Parliament)approved a 50 billion stimulus plan that includes a combination of tax cuts and increased government spending. Germanfederal tax revenue actually rose by 8.5 percent in January, thussqueezing the private sector. The European Commission (EC),which acts as executive of the EU, projects rising budget deficitsacross Euroland that will likely exceed current projections aseconomies collapse. Further, markets are punishing these countries, as exemplified by credit downgrades, rising prices for creditdefault swaps (CDSs), and widening interest rate spreads (e.g.,the 10-year Irish-German spread expanded to 257 basis pointson February 16, even though Ireland’s outstanding governmentdebt was only 41 percent of GDP). Higher interest rates on government debt “crowd out” other government spending andreduce fiscal policy space. While Germany might have room forfiscal stimulus, it is unclear that other nations do.China is a good example of a country’s swift reaction to thecrisis. GDP grew by only 6.8 percent in the last quarter of 2008(down from 13 percent in 2007), so Beijing responded byannouncing a two-year stimulus package approaching 600 billion (nearly as large as that proposed by President Obama), inthe face of projections that 40 million workers would lose theirjobs. The package equals approximately 14 percent of China’sannual GDP, or more than twice the size of the U.S. package relative to their respective economies. When exports fell 2.2 percent in November 2008, the government raised export tax rebatesfor textiles and clothing to 15 percent (from 14 percent) andadopted a plan to support equipment manufacturing. Much ofthe stimulus focused on infrastructure, especially rail lines in thecities and in the relatively underdeveloped rural areas. China isalso spending massively on airports, highways, and water treatment plants, in addition to allocating 123 billion to phase in auniversal health care program within two years (rather than overthe next 11 years as originally planned).This brief argues that an adequate policy response is prohibited by Euroland’s fiscal and monetary arrangements. Thereis a real danger that the euro nations will be unable to prevent anaccelerating slide toward depression that will threaten the veryexistence of the EU. The next section reviews what the Fed hasdone to help the central banks in Europe, then details the problems with the arrangements in Euroland. We argue that the lackof full sovereignty in Euroland limits its ability to respond adequately to the current economic and financial crisis.The Federal Reserve’s Global ResponseThe dollar is the international reserve currency. In spite of scorntoward the dollar and the United States in recent years, the Fedhas come to the rescue of central banks worldwide. There havebeen two types of response to the global financial crisis. The firstis a run to U.S. dollar assets; in particular, U.S. Treasuries, which arethe most liquid asset. The second is a bit more complicated. Inthe face of declining sales revenue and asset values, many international corporations have had to exchange foreign currenciesand liquidate eurodollar assets to cover dollar losses and meetThe Levy Economics Institute of Bard College5
Figure 1 Central Bank Liquidity Swaps,January 2008 July 2009 (in billions of dollars)700Billions of Dollars600500400300200100Jul 2009Jun 2009Apr 2009May 2009Feb 2009Mar 2009Jan 2009Dec 2008Nov 2008Sep 2008Oct 2008Jul 2008Aug 2008Jun 2008Apr 2008May 2008Mar 2008Jan 2008Feb 20080Source: Federal Reserve Statistical Release H.4.1their dollar liabilities. This in turn has pressured both foreigncurrencies and foreign central banks to secure dollars. Inresponse, the Fed has expanded its lending facilities. Further, thefall in the price of oil has resulted in a global “dollar squeeze,”whereby the shrinking supply of “petro dollars” has made therest of the world eager to convert foreign currencies into dollars.The primary way that the Fed lends to foreign central banksis via swap lines—a reciprocal arrangement whereby the Fed creates dollar liabilities and the foreign central banks create liabilities in their own currencies. In terms of the European CentralBank (ECB), the Fed holds euro deposits and issues dollardeposits to the ECB, while the ECB holds dollar deposits andissues euro deposits to the Fed. The ECB is then able to lend dollars to its domestic banks, with the Fed acting as the global lenderof last resort. It is interesting to note that the Fed establishedthese swap lines immediately following its take-over of insurancegiant AIG in September 2008.4 As shown in Figure 1, lendingthrough this channel skyrocketed shortly afterward.What risks does this entail? This question captured theattention of many Americans after Congressman Alan Grayson(D-FL) grilled Fed Chairman Ben Bernanke following his testimony before the House Financial Services Committee in July.Grayson accused Bernanke of making bad lending decisions andpointed to the huge “losses” borne by the Fed as a result of swapline activity. But Grayson got it wrong, because the Fed doesn’tface currency risk when it engages in overseas lending throughswap lines of credit. Swaps are unwound at the same exchangerate that prevailed when the transaction was made. In otherwords, when a foreign central bank draws on its swap line withthe Fed, it sells a specified amount of its currency to the Fed inexchange for dollars at the prevailing market exchange rate. Atthe same time, both central banks enter into a separate contractthat requires them to buy back their own currency on a specified date at the initial exchange rate. Neither bank faces anyexchange rate risk in the transaction.But this does not mean that swap lending is riskless. Indeed,central banks can face significant credit risk due to the possibility of default by foreign borrowers. With respect to Fed lending,this exposes the Fed to substantial credit risk, since swap linesare essentially unsecured loans and foreign central banks cannotservice dollar debts simply by crediting accounts; that is, theyhave to come up with dollars in order to complete the swap at thespecified future date. As Perry Mehrling (2008) notes, “Theselending facilities involve substantial credit risk for the Fed, evenwhen they are collateralized, since eligible collateral now includesany investment grade security whatsoever.”We do not mean to imply that foreign central bank defaultswill threaten the solvency of the U.S. Treasury, which can bearany loss. Rather, this is a political problem. Americans are alreadyhesitant about spending trillions of dollars to rescue U.S. financial institutions, and there is little will to rescue foreign institutions. Until recently, most Americans had no idea that the Fedengaged in such actions, and they do not support the argumentthat this
The Levy Economics Institute of Bard College, founded in 1986, is an autonomous research organization. It is nonpartisan, open to the examination of diverse points of view, and dedicated to public service.
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